Satyam Fraud’s Systemic Regulatory Implications
posted by Lawrence Cunningham
From a systemic regulatory standpoint, the Madoff Ponzi scheme remains of limited significance, especially compared to the latest exposed fraud case, at the large Indian software company, Satyam Computers Services Ltd., whose shares trade on the New York Stock Exchange (in the form of American Depository Receipts, or ADRs). Its CEO released a letter yesterday disclosing an elaborate, and apparently simple, billion-dollar fraud that went undetected by the firm’s outside auditors, an India affiliate of PriceWaterhouseCoopers (PWC).
The Satyam fraud presents serious questions about systemic regulatory efficacy, particularly concerning auditing and audit firm oversight. True, it may seem outlandish that Madoff was able to use a rinky-dink auditing firm to review the books of a fund commanding billions of dollars in assets and it may be that even such small auditing firms of even private funds require as much regulatory supervision as larger auditing firms auditing public enterprises.
But the Satyam scandal presents a far more serious problem. Unlike Madoff, the company has shares listed in the United States. Also unlike Madoff, it was audited by a foreign affiliate of a large US auditing firm, PWC, whose operations apparently were outside the scope of review undertaken by the US auditing profession’s regulatory overseer, the Public Company Accounting Oversight Board (PCAOB).
Pending additional information from the newly-revealed fraud, of course, a couple of preliminary issues may prove to be lessons of the Satyam fraud. First, if foreign companies list securities in the United States, their financial statements need to be audited by a firm whose activities are subject to regulatory oversight in the United States.
Second, the fraud implicates the Securities and Exchange Commission’s recent enthusiasm for the concept of mutual recognition. This refers to a policy allowing foreign firms, especially brokers but potentially also companies and auditors, to access US securities markets without regulatory oversight here, so long as they are subject to comparable regulatory oversight at home. (I have questioned this policy before.)
Third, there is some possibility that audit failures by foreign affiliates of US auditing firms could expose the US firm to crushing legal liability. This could lead to the dissolution of one of the four remaining large US auditing firms (see my post here). Should that occur, with only three such firms standing, the country would face an additional blow to its system of corporate finance, with attendant adversity for the real economy and citizens.
Satyam’s CEO now admits that some reported assets at the company simply did not exist, including considerable amounts of cash. Cash was reported to exceed $1 billion but apparently stands at just $78 million!
Ordinarily, the audit work required to verify the existence of cash is among the easiest of all auditing exercises. One wonders how auditors could have failed to identify such false assertions.
It is likewise the case that the integrity of systems of internal controls governing cash are among the easiest to establish, maintain and audit. Satyam’s auditors gave opinions attesting to the veracity not only of management’s assertions about cash balances but also about the effectiveness of the company’s internal controls. So one also wonders how auditors could have given a clean bill of health to a system of internal control that enabled reporting large amounts of fictitious cash.
Some now will say that the PCAOB bears some responsibility for this fraud and must adjust its policies. PCAOB was created in 2002’s Sarbanes-Oxley Act in response to audit failures, chiefly by erstwhile big-five auditing firm, Arthur Andersen, at companies that turned out to be elaborate frauds, especially Enron and WorldCom. Its responsibilities include inspecting all auditing firms responsible for auditing public companies, those registered with the SEC and listing securities on US capital markets.
Reports indicate that while PCAOB conducts extensive inspections of the four largest auditing firms who together audit the vast majority of US public companies, including PWC, the agency does not conduct inspections of the foreign affiliates of those firms, such as PWC’s Indian affiliate that audited Satyam’s books. Problems apparently include that PCAOB lacks sufficient budget, although it is funded by fees imposed on public companies under a budget it submits to the SEC and the SEC approves.
The problem may grow more serious, however, as the four largest US auditing firms appears increasingly interested in outsourcing much of their auditing work to foreign affiliates, including to firms in India. Investors should be concerned about these developments, especially if the SEC were to continue to pursue its program of mutual recognition and if PCAOB mirrored that policy by relying upon foreign auditing oversight authorities to conduct inspections of auditing firms based abroad.
Hat tip: Lynn Turner